Debt to Equity Ratio & Leverage Ratio

Debt to Equity Ratio

A measure of a company's financial leverage. Debt/equity ratio is equal to long-term debt divided by common shareholders' equity. Typically the data from the prior fiscal year is used in the calculation. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt.

Debt to Equity Ratio:

                                      Long term debt

                                      ----------------

                                         Equity 

For example, if a company has long-term debt of $3,000 and shareholder's equity of $12,000, then the debt/equity ratio would be 3000 divided by 12000 = 0.25. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.

When used to calculate a company's "financial leverage" the debt usually includes only the Long Term Debt (LTD).

Leverage Ratio

1. Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.

2. A ratio used to measure a company's mix of operating costs, giving an idea of how changes in output will affect operating income. Fixed and variable costs are the two types of operating costs; depending on the company and the industry, the mix will differ

ROI and ROTA

Return on Investments

Measure of the earning power of assets. The ratio reveals the firm's profitability on its business operations and thus serves to measure management's effectiveness. It equals Net Income divided by average total assets; also called rate earned on total assets. Other versions of ROI exist, such as net income before interest and taxes divided by average total assets. Return on investment is a commonly used measure to evaluate divisional performance.

Return on Investment:

                                      Net Income before interest and tax

                                      ----------------------------------

                                          Average Total Assets

  

Return on Total assets

A ratio that measures a company's earnings before interest and taxes (EBIT) against its total net assets. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid.

Return on total assets:

                                                EBIT

                                      ----------------

                                      Total Net Assets

Here, EBIT= Net Income + Interest Expense + Taxes.

The greater a company's earnings in proportion to its assets (and the greater the coefficient from this calculation), the more effectively that company is said to be using its assets.

To calculate ROTA, you must obtain the net income figure from a company's income statement, and then add back interest and/or taxes that were paid during the year. The resulting number will reveal the company's EBIT. The EBIT number should then be divided by the company's total net assets (total assets less depreciation and any allowances for bad debts) to reveal the earnings that company has generated for each dollar of assets on its books.

Important financial concepts

Net profit definition:

Often referred to as the bottom line, net profit is calculated by subtracting a company's total expenses from total revenue, thus showing what the company has earned (or lost) in a given period of time (usually one year). also called net income or net earnings.

                                                          OR

Amount of money earned after all expenses, including overhead, employee salaries, manufacturing costs, and advertising costs, have been deducted from the total revenue.

Price Earning Ratio

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:         

                                      Market value per share

                                      ------------------------

                                      Earnings per share (EPS)

Gross Profit Ratio

Gross profit divided by net sales. High ratios are favorable in that they indicate the business is earning a good return on the sale of its merchandise, although that may also invite competition.

Gross profit ratio:

                                      Gross profit

                                      --------------

                                      Net Sales